Tuesday Tools - Private Equity

Discoursers rejoice, data for you!

Hello my pretties. Let’s get you up to speed on the magic of Private Equity.

Background.

Highest priority - particularly if new to to PE

Old, but illustrative explanation of what PE is and does and how.

Overview of PE for someone entering a Financial Career.

Early History of PE.


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Terms you should know.

EBITDA, Earnings Before Interest expenses, Taxes, Depreciation, and Amortization. EBITDA is calculate to give you a gauge of how well the company is actually operating as a company without regard for the CFO’s shenanigans: tax environment, financing, and accounting decisions. This helps you see how much cash a company making before paying its debts. Here’s how to calculate EBITDA and why Warren Buffet doesn’t like it.

EBITDA/Debt ratio, is the relationship between the company’s debts and the cash flows that will be used to pay those debts. The appropriate ratio does vary by industry, but “common” advice suggests that companies in a normal financial state show debt/EBITDA ratio less than 3.  

Ratios higher than 4 or 5 usually set off alarms because they indicate that a company is likely to face difficulties in handling its debt burden, and thus is less likely to be able to raise additional loans required to grow and expand the business.

IRR is the Internal Rate of Return. It’s the 1 to 10 scale that determines the Investor’s tinder swipe. It is an estimate - a quick and dirty evaluation - of an investment’s profitability potential. This is a good page for understanding the difference between IRR and compounded cash flows.

For a solid walkthrough of how to calculate IRR in excel - because you’re ready to take it up a notch - Calculating IRR.

My personal gripe is the assumption that you can reinvest at the IRR. That’s not how business works. But PE seems dedicated to IRR so …

Two and Twenty (no, not blackbirds baked in a pie), 2 and 20 is a common fee structure. It encapsulates both the management fee, 2% of Assets Under Management annually, and 20% gain on the capital gains. This graphic from Dragan Radovanovic at Business Insider shows the fee structure cleanly. Hedge Funds use the same (or used to use) fee structure. A firm can choose different fees and new firms or new funds may need to accept a smaller management fee to attract investors. The 2% management is the “norm” but a highly expert-oriented fund (for example, R&D on medical devices) may be able to charge 3% and a less expert intensive fund (for example, mid-market Industrials) may only charge 1%. The 20% once the fund closes is also negotiable. The investors get their expected return before the Fund gets that 20%.

Helpful

It is a powerhouse of the US (and world) economy.

“If you’re not invested in private equity, or private capital, then you’re really missing out on where our economy is growing.”

Peter Witte, associate director of Ernst & Young’s private equity group

Image from Overvalued, Underrated.

Okay, you love this stuff, can’t get enough:

What about Money Laundering? I get asked about Money Laundering by students who get confused by the language around what PE does, the increased scrutiny and recent spat of legislative publicity. It’s worth a study as a strategy, but it isn’t the aim or focus of PE. Sorry to disappoint.

"Investing Outside the Box: Evidence from Alternative Vehicles in Private Equity
"This paper uses previously unexplored custodial data to examine the use of alternative investment vehicles in private equity over four decades. " So this is a study of the alternative assets within the already alternative asset of Private Equity . . . rabbit hole!

"What Do Private Equity Firms Say They Do?
”…survey of 79 private equity firms managing more than $750 billion in capital, we provide granular information on PE managers’ practices in determining capital structure, valuing transactions, sourcing deals, governance and operational engineering. We also explore how the actions that private equity managers say they take group into specific firm strategies….”

Data Sets

2019 was a strong year for private equity fundraising. In 2019 there was a 35 percent increase in capital committed to private equity funds, when compared to the previous year. Investment volume declined in 2019 to $297 billion from $360 billion the previous year. The percentage of equity contributed to a private equity investment has risen to 47.4 percent in 2019. 

PitchBook from 2019

Fundraising totals surpassed $300 billion for the first time ever as LPs continue to be drawn to the strategy. This annual edition of our flagship US PE report, which is sponsored by INSIGHT2PROFIT, also spotlights tech-focused PE funds and how the strategy and performance differ from traditional buyout funds.

The Economic Effects of Private Equity Buyouts

Bain’s Global Report from 2018

Bain’s Global Report from 2019

The Big Reads for the month on Friday with shorter OpEds on Sunday. And of course, when you’re ready to show your colleagues how smart you are, share.

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